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Time for Europe to scrap launch aid?

Trade Commissioner Peter Mandelson recently gave European aircraft manufacturing nations a frank warning: aircraft subsidies will have to be curbed. But does this mean that the launch-aid mechanism will have to be scrapped altogether?

European Voice

10/5/05, 5:00 PM CET

Updated 4/12/14, 11:59 AM CET

Before the launch of the A350 sets off yet another flurry of transatlantic trade pugilism, the current hiatus offers an opportunity for more reflective stock- taking. Certainly there are economic reasons for preserving launch aid in a subsidy-purged form. But this may not be feasible or expedient in practice.

Launch aid is a form of government support for civil aerospace product development programmes that is repaid through a royalty on subsequent sales. Airbus programmes have received launch- aid support from their respective European shareholders’ govern-ments. With the exception of the US, this form of funding has been used in most civil aerospace manufacturing nations.

Despite the one-time attempt to rebrand launch aid as a ‘loan’ repayable through royalties on sales, the salient features of launch aid are different from debt. Launch aid shifts risk not only differently, but also better than debt or equity. This risk-shifting feature makes launch aid attractive to firms even if it is to be received on subsidy-neutral terms. And because the royalty repayments are triggered by the uncertain evolution of sales – rather than being fixed, as in debt, or being a residual claim, as in equity – it is erroneous to use the debt or equity risk premium to stand in for the launch-aid risk premium. These economic properties provide clues as to the emergence and existence of launch aid per se. After all, if the sole purpose were subsidy delivery, then there would be many other more discreet ways of accomplishing this.

From an economic standpoint, the question of whether a particular launch-aid contract constitutes a subsidy depends on the relationship between the government’s up-front financial contribution and the discounted expected value of royalty repayments. When the former equals the latter, the contract is subsidy neutral. Such an assessment is straightforward when the details of the launch-aid contract are known and the combination of technical and commercial uncertainty is easily priced using market-traded instruments.

But in the case of radically innovative product development programmes, identification of the appropriate probabilities and discount rates is problematic because markets do not exist for ‘pricing’ the fundamental technical and commercial uncertainty. Both sorts of cases may be resolved through an exercise in applied financial economics.

Yet if the manufacturer is easily able to finance the development of a particular product using private sources of finance, as is generally the case with straightforward derivative programmes, it is unlikely that a government will be justified in ‘completing the market’ with launch aid – without conferring a subsidy at the same time.

Although subsidy- neutral launch aid has a number of desirable characteristics, it is precisely to deny such benefits and the possibility of outright subsidy to nascent rivals, notably from Japan and China, that the EU may prefer a deal under which launch aid is scrapped entirely, on the understanding that US indirect support must go as well and that all such government support for civil aerospace would be proscribed on a multilateral basis. In so doing, barriers to entry into the large civil aircraft industry would be raised for prospective entrants, with the likely result of prolonging the Airbus-Boeing duopoly and making the early truncation of either manufacturer’s production less likely.

Therefore despite the good things that subsidy-neutral launch aid could continue to do for European civil aerospace manufacturing, it may be in Airbus’s interests for launch aid to be traded away in order to secure long-term business interests.

But Boeing’s strategy may have already foreclosed such a happy outcome for Europe. Japan Aircraft Development Corporation’s 35% involvement in the Boeing 787 programme is reported to be supported by Japanese launch aid amounting to $1.6 billion (€1.34bn). It is an open question whether Japan and other aspiring aircraft manufacturing nations would be willing, or could be convinced in the course of trade negotiations, to sign up to a treaty that would handicap their ability to enter into or remain within the industry.